Generally, a beneficiary reports the income from an inherited, tax-deferred annuity in the same way as the original owner. There are special rules that apply and flexibility on how to report the income. Whether or not the decedent died before taking systematic withdrawals also affects how the income is reported. The good news is that, often, not all of the annuity is taxable. Sometimes, the entire annuity is taxable, but this is rare.
If you receive a lump-sum distribution, the cost of the annuity is not taxable -- only the earnings. Compute the taxable amount by subtracting the cost from the annuity balance. What is left is ordinary income. You must withdraw the balance of the annuity by the fifth anniversary of the policyholder's death. Withdrawing the funds over a period of years, rather than taking the entire distribution all at once, may reduce your tax liability. If you are the spouse of the decedent, you may treat the annuity as your own.
If the decedent received regular payments from the annuity, payments continue under the terms of the contract to the beneficiary. The amount previously taxable to the policy owner is the amount that is taxable to the beneficiary. All funds must be distributed by the fifth anniversary of the policyholder's death. There is an exception to the five-year rule: If distributions begin before the one-year anniversary of the policyholder's death, payments are spread out over the longer of the decedent's or the beneficiary's life expectancy.
Deduction for Estate Tax
If the beneficiary was the decedent's estate, a deduction for the estate tax is allowed by the beneficiary. The deduction is computed by figuring the deduction with and without the annuity income. The difference is entered on Schedule A of the beneficiaries tax return as a miscellaneous deduction, not subject to the 2-percent adjusted gross income limitation. A tax professional may be necessary, if you are not familiar with estate tax rules.
Tax laws are complex and the aid of a tax professional, such as an enrolled agent or a certified public accountant may be necessary to report annuity income properly. If you're unsure or uncomfortable with preparing your tax return, ask a professional tax preparer to assist you. Inheritances can be large sums of money and under reporting your income may result in a significant IRS penalty and additional tax-preparer fees to amend your tax return.